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Principles of Accounting, Volume 2: Managerial Accounting

6.5 Compare and Contrast Variable and Absorption Costing

Principles of Accounting, Volume 2: Managerial Accounting6.5 Compare and Contrast Variable and Absorption Costing
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  1. Preface
  2. 1 Accounting as a Tool for Managers
    1. Why It Matters
    2. 1.1 Define Managerial Accounting and Identify the Three Primary Responsibilities of Management
    3. 1.2 Distinguish between Financial and Managerial Accounting
    4. 1.3 Explain the Primary Roles and Skills Required of Managerial Accountants
    5. 1.4 Describe the Role of the Institute of Management Accountants and the Use of Ethical Standards
    6. 1.5 Describe Trends in Today’s Business Environment and Analyze Their Impact on Accounting
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Thought Provokers
  3. 2 Building Blocks of Managerial Accounting
    1. Why It Matters
    2. 2.1 Distinguish between Merchandising, Manufacturing, and Service Organizations
    3. 2.2 Identify and Apply Basic Cost Behavior Patterns
    4. 2.3 Estimate a Variable and Fixed Cost Equation and Predict Future Costs
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Cost-Volume-Profit Analysis
    1. Why It Matters
    2. 3.1 Explain Contribution Margin and Calculate Contribution Margin per Unit, Contribution Margin Ratio, and Total Contribution Margin
    3. 3.2 Calculate a Break-Even Point in Units and Dollars
    4. 3.3 Perform Break-Even Sensitivity Analysis for a Single Product Under Changing Business Situations
    5. 3.4 Perform Break-Even Sensitivity Analysis for a Multi-Product Environment Under Changing Business Situations
    6. 3.5 Calculate and Interpret a Company’s Margin of Safety and Operating Leverage
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  5. 4 Job Order Costing
    1. Why It Matters
    2. 4.1 Distinguish between Job Order Costing and Process Costing
    3. 4.2 Describe and Identify the Three Major Components of Product Costs under Job Order Costing
    4. 4.3 Use the Job Order Costing Method to Trace the Flow of Product Costs through the Inventory Accounts
    5. 4.4 Compute a Predetermined Overhead Rate and Apply Overhead to Production
    6. 4.5 Compute the Cost of a Job Using Job Order Costing
    7. 4.6 Determine and Dispose of Underapplied or Overapplied Overhead
    8. 4.7 Prepare Journal Entries for a Job Order Cost System
    9. 4.8 Explain How a Job Order Cost System Applies to a Nonmanufacturing Environment
    10. Key Terms
    11. Summary
    12. Multiple Choice
    13. Questions
    14. Exercise Set A
    15. Exercise Set B
    16. Problem Set A
    17. Problem Set B
    18. Thought Provokers
  6. 5 Process Costing
    1. Why It Matters
    2. 5.1 Compare and Contrast Job Order Costing and Process Costing
    3. 5.2 Explain and Identify Conversion Costs
    4. 5.3 Explain and Compute Equivalent Units and Total Cost of Production in an Initial Processing Stage
    5. 5.4 Explain and Compute Equivalent Units and Total Cost of Production in a Subsequent Processing Stage
    6. 5.5 Prepare Journal Entries for a Process Costing System
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  7. 6 Activity-Based, Variable, and Absorption Costing
    1. Why It Matters
    2. 6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method
    3. 6.2 Describe and Identify Cost Drivers
    4. 6.3 Calculate Activity-Based Product Costs
    5. 6.4 Compare and Contrast Traditional and Activity-Based Costing Systems
    6. 6.5 Compare and Contrast Variable and Absorption Costing
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  8. 7 Budgeting
    1. Why It Matters
    2. 7.1 Describe How and Why Managers Use Budgets
    3. 7.2 Prepare Operating Budgets
    4. 7.3 Prepare Financial Budgets
    5. 7.4 Prepare Flexible Budgets
    6. 7.5 Explain How Budgets Are Used to Evaluate Goals
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Standard Costs and Variances
    1. Why It Matters
    2. 8.1 Explain How and Why a Standard Cost Is Developed
    3. 8.2 Compute and Evaluate Materials Variances
    4. 8.3 Compute and Evaluate Labor Variances
    5. 8.4 Compute and Evaluate Overhead Variances
    6. 8.5 Describe How Companies Use Variance Analysis
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  10. 9 Responsibility Accounting and Decentralization
    1. Why It Matters
    2. 9.1 Differentiate between Centralized and Decentralized Management
    3. 9.2 Describe How Decision-Making Differs between Centralized and Decentralized Environments
    4. 9.3 Describe the Types of Responsibility Centers
    5. 9.4 Describe the Effects of Various Decisions on Performance Evaluation of Responsibility Centers
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  11. 10 Short-Term Decision Making
    1. Why It Matters
    2. 10.1 Identify Relevant Information for Decision-Making
    3. 10.2 Evaluate and Determine Whether to Accept or Reject a Special Order
    4. 10.3 Evaluate and Determine Whether to Make or Buy a Component
    5. 10.4 Evaluate and Determine Whether to Keep or Discontinue a Segment or Product
    6. 10.5 Evaluate and Determine Whether to Sell or Process Further
    7. 10.6 Evaluate and Determine How to Make Decisions When Resources Are Constrained
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  12. 11 Capital Budgeting Decisions
    1. Why It Matters
    2. 11.1 Describe Capital Investment Decisions and How They Are Applied
    3. 11.2 Evaluate the Payback and Accounting Rate of Return in Capital Investment Decisions
    4. 11.3 Explain the Time Value of Money and Calculate Present and Future Values of Lump Sums and Annuities
    5. 11.4 Use Discounted Cash Flow Models to Make Capital Investment Decisions
    6. 11.5 Compare and Contrast Non-Time Value-Based Methods and Time Value-Based Methods in Capital Investment Decisions
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Balanced Scorecard and Other Performance Measures
    1. Why It Matters
    2. 12.1 Explain the Importance of Performance Measurement
    3. 12.2 Identify the Characteristics of an Effective Performance Measure
    4. 12.3 Evaluate an Operating Segment or a Project Using Return on Investment, Residual Income, and Economic Value Added
    5. 12.4 Describe the Balanced Scorecard and Explain How It Is Used
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  14. 13 Sustainability Reporting
    1. Why It Matters
    2. 13.1 Describe Sustainability and the Way It Creates Business Value
    3. 13.2 Identify User Needs for Information
    4. 13.3 Discuss Examples of Major Sustainability Initiatives
    5. 13.4 Future Issues in Sustainability
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Thought Provokers
  15. Financial Statement Analysis
  16. Time Value of Money
  17. Suggested Resources
  18. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
  19. Index

ABC costing assigns a proportion of overhead costs on the basis of the activities under the presumption that the activities drive the overhead costs. As such, ABC costing converts the indirect costs into product costs. There are also cost systems with a different approach. Instead of focusing on the overhead costs incurred by the product unit, these methods focus on assigning the fixed overhead costs to inventory.

There are two major methods in manufacturing firms for valuing work in process and finished goods inventory for financial accounting purposes: variable costing and absorption costing. Variable costing, also called direct costing or marginal costing, is a method in which all variable costs (direct material, direct labor, and variable overhead) are assigned to a product and fixed overhead costs are expensed in the period incurred. Under variable costing, fixed overhead is not included in the value of inventory. In contrast, absorption costing, also called full costing, is a method that applies all direct costs, fixed overhead, and variable manufacturing overhead to the cost of the product. The value of inventory under absorption costing includes direct material, direct labor, and all overhead.

The difference in the methods is that management will prefer one method over the other for internal decision-making purposes. The other main difference is that only the absorption method is in accordance with GAAP.

Variable Costing Versus Absorption Costing Methods

The difference between the absorption and variable costing methods centers on the treatment of fixed manufacturing overhead costs. Absorption costing “absorbs” all of the costs used in manufacturing and includes fixed manufacturing overhead as product costs. Absorption costing is in accordance with GAAP, because the product cost includes fixed overhead. Variable costing considers the variable overhead costs and does not consider fixed overhead as part of a product’s cost. It is not in accordance with GAAP, because fixed overhead is treated as a period cost and is not included in the cost of the product.

Concepts In Practice

Absorbing Costs through Overproduction

While companies use absorption costing for their financial statements, many also use variable costing for decision-making. The Big Three auto companies made decisions based on absorption costing, and the result was the manufacturing of more vehicles than the market demanded. Why? With absorption costing, the fixed overhead costs, such as marketing, were allocated to inventory, and the larger the inventory, the lower was the unit cost of that overhead. For example, if a fixed cost of $1,000 is allocated to 500 units, the cost is $2 per unit. But if there are 2,000 units, the per-unit cost is $0.50. While this was not the only reason for manufacturing too many cars, it kept the period costs hidden among the manufacturing costs. Using variable costing would have kept the costs separate and led to different decisions.

Deferred Costs

Absorption costing considers all fixed overhead as part of a product’s cost and assigns it to the product. This treatment means that as inventories increase and are possibly carried over from the year of production to actual sales of the units in the next year, the company allocates a portion of the fixed manufacturing overhead costs from the current period to future periods.

Carrying over inventories and overhead costs is reflected in the ending inventory balances at the end of the production period, which become the beginning inventory balances at the start of the next period. It is anticipated that the units that were carried over will be sold in the next period. If the units are not sold, the costs will continue to be included in the costs of producing the units until they are sold. Finally, at the point of sale, whenever it happens, these deferred production costs, such as fixed overhead, become part of the costs of goods sold and flow through to the income statement in the period of the sale. This treatment is based on the expense recognition principle, which is one of the cornerstones of accrual accounting and is why the absorption method follows GAAP. The principle states that expenses should be recognized in the period in which revenues are incurred. Including fixed overhead as a cost of the product ensures the fixed overhead is expensed (as part of cost of goods sold) when the sale is reported.

For example, assume a new company has fixed overhead of $12,000 and manufactures 10,000 units. Direct materials cost is $3 per unit, direct labor is $15 per unit, and the variable manufacturing overhead is $7 per unit. Under absorption costing, the amount of fixed overhead in each unit is $1.20 ($12,000/10,000 units); variable costing does not include any fixed overhead as part of the cost of the product. Figure 6.11 shows the cost to produce the 10,000 units using absorption and variable costing.

Absorption and Variable, respectively. Materials ($3 per unit) $30,000, $30,000. Labor ($15 per unit) 150,000, 150,000. Variable Overhead ($7 per unit) 70,000, 70,000. Fixed Overhead ($1.20 per unit) 12,000. Total Finished Goods Inventory $262,000, $250,000.
Figure 6.11 Finished Goods Inventory under Absorption and Variable Costing. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Assume each unit is sold for $33 each, so sales are $330,000 for the year. If the entire finished goods inventory is sold, the income is the same for both the absorption and variable cost methods. The difference is that the absorption cost method includes fixed overhead as part of the cost of goods sold, while the variable cost method includes it as an administrative cost, as shown in Figure 6.12. When the entire inventory is sold, the total fixed cost is expensed as the cost of goods sold under the absorption method or it is expensed as an administrative cost under the variable method; net income is the same under both methods.

Absorption and Variable, respectively. Sales $330,000, $330,000. Less Cost of Goods Sold 262,000, 250,000. Equals Gross Profit 68,000, 80,000. Less Fixed Overhead 0, 12,000. Equals Net Income $68,000, $68,000.
Figure 6.12 Income Statement When the Entire Inventory Is Sold. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Now assume that 8,000 units are sold and 2,000 are still in finished goods inventory at the end of the year. The cost of the fixed overhead expensed on the income statement as cost of goods sold is $9,600 ($1.20/unit × 8,000 units), and the fixed overhead cost remaining in finished goods inventory is $2,400 ($1.20/unit × 2,000 units). The amount of the fixed overhead paid by the company is not totally expensed, because the number of units in ending inventory has increased. Eventually, the fixed overhead cost will be expensed when the inventory is sold in the next period. Figure 6.13 shows the cost to produce the 8,000 units of inventory that became cost of goods sold and the 2,000 units that remain in ending inventory.

Absorption and Variable, respectively. Cost of Goods Sold: Materials $24,000, $24,000; Labor 120,000, 120,000; Variable Overhead 56,000, 56,000; Fixed Overhead 9,600. Cost of Goods Sold $209,600, $200,000. Ending Inventory: Materials $6,000, $6,000; Labor 30,000, 30,000; Variable Overhead 14,000, 14,000; Fixed Overhead 2,400. Ending Inventory $52,400, $50,000.
Figure 6.13 Cost of Goods Sold and Ending Inventory with the Absorption and Variable Costing Methods. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

If the 8,000 units are sold for $33 each, the difference between absorption costing and variable costing is a timing difference. Under absorption costing, the 2,000 units in ending inventory include the $1.20 per unit share, or $2,400 of fixed cost. That cost will be expensed when the inventory is sold and accounts for the difference in net income under absorption and variable costing, as shown in Figure 6.14.

Absorption and Variable, respectively. Sales $264,000, $264,000. Less Cost of Goods Sold 209,600, 200,000. Equals Gross Profit of 54,400, 64,000. Less Fixed Overhead of 0, 12,000. Equals Net Income of $54,400, $52,000.
Figure 6.14 Net Income under Absorption and Variable Costing When Ending Inventory Remains. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Under variable costing, the fixed overhead is not considered a product cost and would not be assigned to ending inventory. The fixed overhead would have been expensed on the income statement as a period cost.

Inventory Differences

Because absorption costing defers costs, the ending inventory figure differs from that calculated using the variable costing method. As shown in Figure 6.13, the inventory figure under absorption costing considers both variable and fixed manufacturing costs, whereas under variable costing, it only includes the variable manufacturing costs.

Suitability for Cost-Volume-Profit Analysis

Using the absorption costing method on the income statement does not easily provide data for cost-volume-profit (CVP) computations. In the previous example, the fixed overhead cost per unit is $1.20 based on an activity of 10,000 units. If the company estimated 12,000 units, the fixed overhead cost per unit would decrease to $1 per unit. This calculation is possible, but it must be done multiple times each time the volume of activity changes in order to provide accurate data, as CVP analysis makes no distinction between variable costing and absorption costing income statements.

Your Turn

Comparing Variable and Absorption Methods

A company expects to manufacture 7,000 units. Its direct material costs are $10 per unit, direct labor is $9 per unit, and variable overhead is $3 per unit. The fixed overhead is estimated at $49,000. How much would each unit cost under both the variable method and the absorption method?

Solution

The variable cost per unit is $22 (the total of direct material, direct labor, and variable overhead). The absorption cost per unit is the variable cost ($22) plus the per-unit cost of $7 ($49,000/7,000 units) for the fixed overhead, for a total of $29.

Advantages and Disadvantages of the Variable Costing Method

Variable costing only includes the product costs that vary with output, which typically include direct material, direct labor, and variable manufacturing overhead. Fixed overhead is not considered a product cost under variable costing. Fixed manufacturing overhead is still expensed on the income statement, but it is treated as a period cost charged against revenue for each period. It does not include a portion of fixed overhead costs that remains in inventory and is not expensed, as in absorption costing.

If absorption costing is the method acceptable for financial reporting under GAAP, why would management prefer variable costing? Advocates of variable costing argue that the definition of fixed costs holds, and fixed manufacturing overhead costs will be incurred regardless of whether anything is actually produced. They also argue that fixed manufacturing overhead costs are true period expenses and have no future service potential, since incurring them now has no effect on whether these costs will have to be incurred again in the future.

Advantages of the variable approach are:

  • More useful for CVP analysis. Variable costing statements provide data that are immediately useful for CVP analysis because fixed and variable overhead are separate items. Computations from financial statements prepared with absorption costing need computations to break out the fixed and variable costs from the product costs.
  • Income is not affected by changes in production volume. Fixed overhead is treated as a period cost and does not vary as the volume of inventory changes. This results in income increasing in proportion to sales, which may not happen under absorption costing. Under absorption costing, the fixed overhead assigned to a cost changes as the volume changes. Therefore, the reported net income changes with production, since fixed costs are spread across the changing number of units. This can distort the income picture and may even result in income moving in an opposite direction from sales.
  • Understandability. Managers may find it easier to understand variable costing reports because overhead changes with the cost driver.
  • Fixed costs are more visible. Variable costing emphasizes the impact fixed costs have on income. The total amount of fixed costs for the period is reported after gross profit. This emphasizes the direct impact fixed costs have on net income, whereas in absorption costing, fixed costs are included as product costs and thus are part of cost of goods sold, which is a determinant of gross profit.
  • Margins are less distorted. Gross margins are not distorted by the allocation of common fixed costs. This facilitates appraisal of the profitability of products, customers, and business segments. Common fixed costs, sometimes called allocated fixed costs, are costs of the organization that are shared by the various revenue-generating components of the business, such as divisions. Examples of these costs include the chief executive officer (CEO) salary and corporate headquarter costs, such as rent and insurance. These overhead costs are typically allocated to various components of the organization, such as divisions or production facilities. This is necessary, because these costs are needed for doing business but are generated by a part of the company that does not directly generate revenues to offset these costs. The company’s revenues are generated by the goods that are produced and sold by the various divisions of the company.
  • Control is facilitated. Variable costing considers only variable production costs and facilitates the use of control mechanisms such as flexible budgets that are based on differing levels of production and therefore designed around variable costs, since fixed costs do not change within a relevant range of production.
  • Incremental analysis is more straightforward. Variable cost corresponds closely with the current out-of-pocket expenditure necessary to manufacture goods and can therefore be used more readily in incremental analysis.

While the variable cost method helps management make decisions, especially when the number of units in ending inventory fluctuates, there are some disadvantages:

  • Financial reporting. The variable cost method is not acceptable for financial reporting under GAAP. GAAP requires expenses to be recognized in the same period as the related revenue, and the variable method expenses fixed overhead as a period cost regardless of how much inventory remains.
  • Tax reporting. Tax laws in the United States and many other countries do not allow variable costing and require absorption costing.

Advantages and Disadvantages of the Absorption Costing Method

Under the absorption costing method, all costs of production, whether fixed or variable, are considered product costs. This means that absorption costing allocates a portion of fixed manufacturing overhead to each product.

Advocates of absorption costing argue that fixed manufacturing overhead costs are essential to the production process and are an actual cost of the product. They further argue that costs should be categorized by function rather than by behavior, and these costs must be included as a product cost regardless of whether the cost is fixed or variable.

The advantages of absorption costing include:

  • Product cost. Absorption costing includes fixed overhead as part of the inventory cost, and it is expensed as cost of goods sold when inventory is sold. This represents a more complete list of costs involved in producing a product.
  • Financial reporting. Absorption costing is the acceptable reporting method under GAAP.
  • Tax reporting. Absorption costing is the method required for tax preparation in the United States and many other countries.

While financial and tax reporting are the main advantages of absorption costing, there is one distinct disadvantage:

  • Difficulty in understanding. The absorption costing method does not list the incremental fixed overhead costs and is more difficult to understand and analyze as compared to variable costing.

Ethical Considerations

Cost Accounting for Ethical Business Managers

An ethical and evenhanded approach to providing clear and informative financial information regarding costing is the goal of the ethical accountant. Ethical business managers understand the benefits of using the appropriate costing systems and methods. The accountant’s entire business organization needs to understand that the costing system is created to provide efficiency in assisting in making business decisions. Determining the appropriate costing system and the type of information to be provided to management goes beyond providing just accounting information. The costing system should provide the organization’s management with factual and true financial information regarding the organization’s operations and the performance of the organization. Unethical business managers can game the costing system by unfairly or unscrupulously influencing the outcome of the costing system’s reports.

Comparing the Operating Income Statements for Both Methods Assuming No Ending Inventory in the First Year, and the Existence of Ending Inventory in the Second Year

In order to understand how to prepare income statements using both methods, consider a scenario in which a company has no ending inventory in the first year but does have ending inventory in the second year. Outdoor Nation, a manufacturer of residential, tabletop propane heaters, wants to determine whether absorption costing or variable costing is better for internal decision-making. It manufactures 5,000 units annually and sells them for $15 per unit. The total of direct material, direct labor, and variable overhead is $5 per unit with an additional $1 in variable sales cost paid when the units are sold. Additionally, fixed overhead is $15,000 per year, and fixed sales and administrative expenses are $21,000 per year.

Production is estimated to hold steady at 5,000 units per year, while sales estimates are projected to be 5,000 units in year 1; 4,000 units in year 2; and 6,000 in year 3.

Under absorption costing, the ending inventory costs include all manufacturing costs, including overhead. If fixed overhead is $15,000 per year and 5,000 units are manufactured each year, the fixed overhead per unit is $3:

$15,0005,000units=$3per unit$15,0005,000units=$3per unit

The projected income statement using absorption costing is shown in Figure 6.15:

Year 1, Year 2, and Year 3, respectively. Sales $75,000, $60,000, $90,000. Less Cost of Goods Sold: Beginning Inventory, 0, 0, 8,000. Plus Cost of Goods Manufactured: Direct Material, Labor and Overhead (5,000 units x $5 per unit), 25,000, 25,000, 25,000. Plus Fixed Manufacturing Overhead 15,000, 15,000, 15,000. Equals Cost of Goods Available for Sale, 40,000, 40,000, 48,000. Less Ending Inventory, 0, 8,000, 0. Equals Cost of Goods Sold, 40,000, 32,000, 48,000. Equals Gross Margin 35,000, 28,000, 42,000. Less Sales and Administrative Expenses: Fixed Sales and Admin Expenses 21,000, 21,000, 21,000 and Variable Sales and Admin Expenses 5,000, 4,000, 6,000. Equals Net Income $9,000, $3,000, $15,000.
Figure 6.15 Outdoor Nation’s Income Statement Using Absorption Costing. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

In variable costing, the fixed overhead is not included in the cost of goods sold even if it relates to manufacturing. As a result, the net income under variable costing differs from absorption costing by the same amount as inventory differential. The projected income under variable costing is shown in Figure 6.16:

Year 1, Year 2, and Year 3 respectively. Sales $75,000, $60,000, $90,000. Less Variable Expenses: Beginning Inventory 0, 0, 5,000. Plus Variable Manufacturing Overhead 25,000, 25,000, 25,000. Equals Cost of Goods Available for Sale 25,000, 25,000, 30,000. Less Ending Inventory 0, 5,000, 0. Equals Variable Cost to Manufacturing 25,000, 20,000, 30,000. Variable Selling and Administrative Expenses 5,000, 4,000, 6,000. Equals Cost of Goods Sold 30,000, 24,000, 36,000. Contribution Margin 45,000, 36,000, 54,000. Less Fixed Expenses: Fixed Overhead Expenses 15,000, 15,000, 15,000 and Fixed Slaes and Admin Expenses 21,000, 21,000, 21,000. Equals Net Income $9,000, $0, $18,000.
Figure 6.16 Outdoor Nation’s Income Statement Using Variable Costing. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

The difference between the methods is attributable to the fixed overhead. Therefore, the methods can be reconciled with each other, as shown in Figure 6.17.

Reconciliation for Year 1, Year 2, and Year 3, respectively. Income Under Variable Costing, $9,000, $0, $18,000. Plus Fixed Manufacturing Overhead in Ending Inventory 0, 3,000, 0. Minus Fixed Manufacturing Overhead in Beginning Inventory 0, 0, 3,000. Equals Income Under Absorption $9,000, $3,000, $15,000.
Figure 6.17 Outdoor Nation’s Reconciliation of Net Incomes. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Each method results in different amounts for net income when the inventory amounts change. More specifically, the effects on income are:

  • Sales and Production equal. When a company sells the same quantity of products produced during the period, the resulting net income will be identical whether absorption costing or variable costing is used. When sales equals production, all manufacturing costs are accounted for in net income, and none of the costs are waiting in finished goods inventory to be recognized in a future period. Remember, with absorption costing, all manufacturing costs are added to the cost of the product during the work in process phase; thus, as the goods are sold, all costs have been accounted for. With variable costing, only the variable costs or production are added to the cost of the product during the work in process phase, and the fixed costs are expensed in the period in which they are incurred. Thus, in the example where sales and production are equal, all costs have been accounted for since all of the produced inventory has moved through cost of goods sold. This means that net income under absorption costing would be the same as net income under variable costing.
  • Sales less than Production. When a company produces more than it sells, net income will be less under variable costing than under absorption costing. In this scenario, there will be a buildup, or an increase, in inventory from the beginning of the period to the end of the period. Under variable costing, fixed manufacturing costs are still in the finished goods inventory account. But under absorption costing, those fixed costs have been expensed during the current production period and thus have reduced net income.
  • Sales greater than Production. When a company sells more than it produces during the current period, this indicates it is selling goods produced in a prior period. This will result in net income under variable costing being greater than under absorption costing. With absorption costing, all manufacturing costs are captured in the finished goods inventory account, and as those goods are sold, those costs become expenses. Selling items that were produced in a prior period defers the recognition of the costs of those products until the future period in which they are sold. Variable costing results in all of the variable costs associated with the sold products being in the current period net income, but only the current period fixed expenses would be included in the current period net income. The fixed expenses associated with the items produced in a prior period were recognized in the period in which they were incurred, not the period in which the products are sold. This results in fewer expenses and therefore greater income with the variable cost method.
  • Effect of differences in Sales and Production Long Term. The differences between net income generated under absorption costing and variable costing will be almost zero over the long run, as all costs associated with the production of goods will eventually be recognized in net income. The use of absorption versus variable costing creates more of a timing issue for the recognition of fixed expenses, and this is why net income would vary from period to period under the two methods but in the long run would not. In addition, absorption costing does allow for manipulation of income by managers through overproduction. Increasing production at year-end results in a higher net income than if the additional goods had not been produced, since increasing the number of units decreases the fixed cost per unit. Under absorption costing, these fixed costs follow the units produced and do not become a part of cost of goods sold until they are sold. Instead, a portion of the fixed costs is in the inventory accounts. Why would a manager want to manipulate income by overproducing? If the manager’s annual bonus or other compensation is linked to net income, then the manager may be motivated to overproduce in order to increase the potential for or the amount of a bonus. If the level of sales remain constant while manipulating the production level, such an action would increase the company’s expenses (including the amount of bonus) while not increasing its revenue. Barring any other justification for the increase in production, such an action by the manager would typically be considered an ethical violation, since the manager’s actions would be in the manager’s best interests, but contrary to the best interests of the company.
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